College savings plans have been around since 1996 and more recently (2006) Congress enhanced them with some advantages. This is great news for those of us who want to set money aside to help fund our children’s college education, including grandparents and godparents. When our own children were born, we jump started each child’s account with a seed amount followed by sizeable monthly contributions. The goal was to fund each child at 90% of a public university.
So we’re feeling great about these early actions. We give ourselves a little pat on the back when the statements arrive.
Not too after, we began investing in real estate in earnest, which caused us to revisit our investments including these savings plans. We had always known this, but the market downturn of late pounded this home: investing in different types of stocks, bonds, mutual funds is good diversification – but only as long as the paper assets market doesn’t nose-dive!!
This, of course applied to our college funding strategy. While the tax benefits are valuable, we learned a major drawback was that real estate holdings are not allowed. REITS perhaps but those are not securitized by specificproperties, and we’ve all heard the horror stories of derivatives.
So, we came up with a modified approach. We’ll still take advantage of the 529 plans already set up and will continue to contribute, but we’re going to make our dollars work harder. Below are a few options depending on your personal investment goal, college funding goal and your financial situation. The concept is simple: invest in real estate first and then use rental income to contribute to the college savings plans.
Core concept: Buy rental property
If you have limited capital, try to buy one rental house. There are creative ways to go about buying a rental property with little money out of pocket.
If you purchased it right, you can net $180-210/month from the rental house. Then take those proceeds and put that into your children’s college savings account.
Heads up! Make sure you buy right— meaning your calculations are based on reliable rent levels for several years (called your holding period) and you have appropriately planned for expenses associated with owning that rental property. If you just pocket the difference between rent and PITI (principal, interest, taxes, insurance), you will need to cover additional expenses on your own when you have vacancies or maintenance items and capital improvements. If you put too much away in the college savings account, it’s painful and costly to pull that money out to replace the old and finally broken water heater, pay emergency appliance repairs, mortgage payment if unit is empty, etc.
|$20,000||20% Down payment|
|$3,000||Settlement costs from escrow|
|$23,000||Your out-of-pocket to acquire the property with a conventional loan*|
|$388||Monthly mortgage ($80,000 loan, 4.125% rate for 30 year fixed loan)|
|$204||Monthly property insurance and taxes|
|$100||Property management expense (10% of monthly rent, this rate is fairly common). Or eliminate this if you are self-managing.|
|%70||Monthly maintenance reserves (7% of your rental)|
|$50||Miscellaneous expenses (supplies, period yard clean up, pest control)|
|$200||Cashflow per month|
*Technically you have prepaids at closing but these are all monthly costs of interest, taxes and insurance you be paying anyway. You pay the piper sooner or later.
At the end of 10 years, your children can access the college savings plan and you sell the house to get back your initial investment and rest goes towards college.
1) You earn over $34,000 in the college savings plans (assume 7.5% market return)
2) Sell the house for $135,000 (assume 3% appreciation each year)
- Pay off the loan $63000 plus transaction costs $12,000
- Pay yourself back the initial $23000 invested (or more if you want to earn something extra for your own investment)
- Remainder to college $37000
3) Total going towards college is $71,000
Did you see the power of leverage and making the money work twice? With your initial $23,000 down payment and costs to close on the deal, you secured a property at a record low loan rate, the tenant’s rent gives you about $200/month to apply towards college AND the equity you accumulated as the property slowly rose in value yielded more money for college. If you just took $200 from your paycheck and put into the college fund, you get that $34,000 in 10 years but not the $37,000. And don’t forget the tax benefits of write-offs and depreciation too!
Variation 1: Buy 1-2 per child
Now, you might be pooh-poohing on the Core Concept because you’ve seen the projected costs of tuition. That’s understandable. The point is to show you how leverage works and making the most of one’s situation.
If you have more capital, all the power to you. Buy 1-2 houses per child and direct all cashflow per month into each of their savings plan.
Variation 2: Do this but don’t sell the houses. Keep them as YOUR rental portfolio to fund your retirement
Variation 3: Do this and then hand over the management and/or maybe ownership to the children to teach them the benefits and responsibilities of buying and holding rentals. You can give them the properties AFTER they graduate to fund their own ventures or business. (Be careful! I didn’t say adventures as in a round-the-world post-graduation trip).